Definition

The term liquidity is used to describe the relative time it takes until an asset is converted into cash, or the payment of a liability is due. Liquidity is a comparative term, meaning it may be easier to convert one asset into cash than another.

Explanation

Different industries will have various degrees of liquidity. The challenge for the company's management team is to balance the need to invest in income-producing assets versus the near term need for cash to pay invoices for products and services as they come due. A shortage of liquidity can result in the inability to pay creditors and eventually lead to bankruptcy. Unfortunately, cash is not an income-producing asset; therefore, the company foregoes some opportunity to expand operations when holding cash.

Liquidity ratios allow analysts, investors, and creditors to quickly identify if a company may have trouble meeting its debt obligations coming due in the next twelve months. The most commonly used measures of liquidity include the cash, current, and quick ratios.

The cash ratio is the most rigorous test of a company's ability to satisfy short term debt. While the current ratio allows for all current assets in its calculation, the cash ratio limits the liquid assets to cash and marketable securities. Generally, a cash ratio value that approaches 1.0 is considered satisfactory. When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.